Millions of undergraduates could pay higher interest rates on loans because universities were “severely at risk” from budget cuts imposed to service Britain’s debt, it was claimed.

The Russell Group said the present system was “regressive” because it benefited middle-class graduates as much as those from poor backgrounds.

Universities are already facing a deficit of at least £1.1 billion in the next three years and the group – which represents institutions such as Oxford, Cambridge and University College London – insisted that significant investment was vital to maintain standards.

The comments were made in its submission to an independent review of the student funding system being led by Lord Browne, the former head of BP.

The review team has already been put under pressure to raise tuition fees above the current level of £3,200, with some vice-chancellors suggesting that the charge should more than double to £7,000.

Dr Wendy Piatt, Russell Group director general, said: “The UK now stands at a crossroads – without more investment in higher education, the UK risks jeopardising the competitive advantage which has made its universities the envy of the world."

Lord Browne's review is due to report back to Parliament in the autumn.

It already has the potential to be among the most contentious issues facing the new coalition government. The Conservatives have refused to rule out supporting a tuition fee rise, but the Liberal Democrats have called for fees to be axed altogether.

Under the current system, students can take out loans to cover the cost of fees and living expenses. Loans are set at a low interest rate and are subsidised by the taxpayer.

Students start paying back loans when they earn at least £15,000 a year or more - at a lower interest rate than the government’s cost of borrowing.

But the Russell Group insisted the present system was unfair as it benefited wealthy graduates.

The organisation’s submission said: "The lack of a real rate of interest on student loans is therefore a subsidy which imposes high costs on the Government, and which exceeds the requirements of ensuring fair access to higher education.

"Moreover, it is a subsidy which is targeted towards better-off graduates. As it represents a re-distribution of funds from the worse off to the best off, it is therefore a highly regressive policy.

"One way of modifying the current system is therefore that student loans should carry a real rate of interest; one which would be equivalent to the Government's overall cost of borrowing."

The document said that the public cost of funding the student finance system could be reduced by lowering the threshold at which graduates begin paying back loans – meaning repayments would kick in for those earning less than £15,000.

The rate of repayment could also be increased, the Russell Group said, which could have an impact on the size of the contributions made.

The group suggested there were three "realistic" ways to remedy the current level of annual deficit, including cutting staff, raising fees for British undergraduates and imposing higher costs on foreign students.

Although the submission stopped short of suggesting higher tuition fees for British students, it appeared to indicate that other solutions may not be fully workable.

"Russell Group universities might be able to increase revenues by raising fees from international students, but pushing such a strategy too far could be risky, endangering the reputation of UK universities overseas and ultimately placing in jeopardy the stability of the UK international student market," it said.

But Sally Hunt, general secretary of the University and College Union, said: “We desperately need to overhaul how universities are funded and move away from the idea that the current review of student funding is merely a question of how much student fees go up by.”